Why Private Equity May Not Be a Good Investment

Last Updated Apr 6, 2010 2:44 PM EDT

In our last post, we saw that the historical evidence has shown that private equity strategies haven't been worth with the risks involved. It gets worse when you consider everything you're giving up.

When you invest in private equity, you give up the benefits of liquidity, transparency, broad diversification and access to daily pricing that you get with mutual funds. Also keep in mind that private equity investments typically entail long lockout periods, during which you can't access your capital. And taxable private equity investors can't harvest interim losses for tax purposes. Here are a few other aspects of the asset class you should consider carefully.

Skewness
The median return of private equity is much lower than the mean (the arithmetic average) return. This means there's a small possibility of a truly outstanding return and a much larger probability of a more modest or negative return. In effect, private equity investments are like lottery tickets: They provide a small chance of a huge payout, but a much larger chance of a below average return.

Standard Deviation
The standard deviation of private equity is more than 100 percent. The standard deviations of the S&P 500 Index and small-cap value stocks of about 21 and 35 percent, respectively.
Diversification
Private equity investing means concentrating on a few investments, rather than broadly diversifying across hundreds or even thousands of stocks (like mutual funds do). This involves accepting the risk that such investments may produce a wide dispersion of returns. While a large institutional investor such as the California Public Employees' Retirement System can diversify its exposure to private equity investments across many funds, it's unlikely that typical individuals can. Thus, it's unlikely that the returns individuals receive are going to be similar to the overall return to private equity.

If you invest in private equity and can't diversify your holdings, this means you are accepting uncompensated risk -- because it could be diversified away. Remember that because of the wide dispersion of private equity returns and the positive skewness of the investments, you're more likely to end up with below average returns instead of above average returns.

Before you consider investing in private equity, you should consider the following advice from David Swensen, the noted chief investment officer who oversees Yale University's highly successful endowment: "Understanding the difficulty of identifying superior hedge fund, venture capital and leveraged buyout investments leads to the conclusion that hurdles for casual investors stand insurmountably high. Even many well-equipped investors fail to clear the hurdles necessary to achieve consistent success in producing market-beating, active management results. When operating in arenas that depend fundamentally on active management for success, ill-informed manager selection poses grave risks to portfolio assets."
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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

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